There has always been a contingent that has preached a 100% stock
strategy. Justification goes something like this: stocks outperform
bonds and cash in the long-term so why hold anything else that will
just drag down your return? This argument has intuitive appeal but it
ignores key fundamentals of investor behaviour and portfolio
construction.

The long-term

The mutual fund industry is notorious for watering down what I
consider to be a proper definition of 'long-term'. It's not unusual to
hear 'five years' as the definition of a long-term holding
period. While a five-year holding period for stocks will usually
result in a positive return, substantial losses can be (and have been)
experienced over five-year holding periods.

For example, the MSCI EAFE C$ index saw a loss of 28% from March 1998
through March 2003. Canadian stocks lost more than 9% over this same
period. From August 2000 through August 2005, the S&P 500 C$ lost 30%
of its value. Going back further in time would reveal more substantial
losses but you get the point. On the other hand, I could not find a
period where bonds suffered losses over a five-year period. That
doesn't mean it has never happened (or never will) but there is
clearly less downside risk with bonds.

The role of bonds and cash

This brings us to the role of bonds in a portfolio. Once upon a time,
when bond yields were relatively high (in nominal terms); people used
them to produce income. Today, with gross yields of 4% to 4.5%, it is
difficult to get a sufficient level of income from such low
yields. This challenge is exponentially tougher when you consider the
average bond fund sports an annual management expense ratio of 1.5%
per year.

Bonds, however, should be viewed as a portfolio stabilizer. It's true
that rate hikes put pressure on both stocks and bonds. But when you
need the diversifying power of bonds most - i.e. in recessionary times
- they tend to deliver. In slow economic times, economic activity
slows. This prompts central banks to, at best, lower interest rates
(great for bonds) or, at worst, leave rates alone (which means bonds
will post positive returns).

So, even though their future return potential is nothing to brag
about, bonds serve an important role in most investment portfolios - a
role that is more important after four years of strongly recovering
stock markets.

Even if you like the 'all-stocks all the time' portfolio strategy,
there is the little fact that most investors cannot handle the ups and
downs that come with 100% stock portfolios. This is the case even for
investors who say or think that they can. This is not meant in a
patronizing tone but the person who can truly predict how he will feel
in a stressful situation not previously experienced is rare, if he
exists at all.

In my many years in counselling individual investors, I have found the
most challenging aspect to be fully capturing the client's true
tolerance for the ups and downs of the market. This phenomenon, which
is admittedly anecdotal, is consistent across occupations and income
levels. But it tends to be more prominent among investors with larger
portfolios (i.e. over $500k).

My general rule is to assume an investor's stated risk tolerance is
higher than its true level, unless they have knowingly experienced a
bear market with a sum of money that resembles their current portfolio
size. (I say 'knowingly' because some clients may not have had enough
interest to look at their statements during past bears, which means
they never saw the falling monthly or quarterly values.)

Portfolio guidelines

Benjamin Graham wrote that investors should keep a minimum of 25% in
each of bonds and stocks. This means that the maximum allocation to
either is 75 percent. These are guidelines that make a great deal of
sense, despite that fact that Graham articulated these rules many
decades ago. Proper diversification within the stock component remains
important, but these are guidelines I continue to use today when
constructing portfolios.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in
Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and
provides independent investment research to financial advisors. He can be
reached at dha@danhallett.com

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